In a very different age (2004) when the euro traded well above the dollar (1.30 in late 2004, as opposed to .999 today), Jean-Claude Trichet, the then chief of the European Central Bank declared that ‘brutal’ moves in the euro were unwelcome. His use of the word ‘brutal’ – it has a far stronger meaning in English than in French – and he, as the son of a literature professor might have known better – led to even more jumpiness in markets.
A couple of years later (July 2008), Trichet made another, school-boy error – raising interest rates in an apparent response to a spike in the price of oil. Coming one month before the biggest financial crisis in recent history, it was a clumsy move given, in any case, the tenuous relationship between the price of oil and euro-zone rates. It was also a mistake that set the scene for the rest of Trichet’s stewardship of the euro-zone during its crisis period.
It is a case study that is worth examining again in the light of last week’s ECB meeting where rates were raised by 0.75% and where the ECB expects inflation to persist above 5% through 2023, having confidently forecast it closer to 2% at the start of this year. The ECB cannot expect that the blunt instrument of monetary policy will have any effect on gas and electricity prices – both of which are driven by market micro-structures and the complexities of geopolitics.
At the same time, the ECB like the Fed, is privately aware of the embarrassing inaccuracy of its forecasts (see our note of November 2021 ‘Pantomime Monetary Policy’) and the risk that a decade of easy monetary policy has let the inflation genie loose (see property and service price inflation for instance). For that reason, I suspect that the ECB, like other central banks, will continue to lean against inflation, with the high risk that we see a recession in Europe by year end. Markets are currently pricing in 2% in interest rate hikes up to next March, even as European manufacturing activity and consumer sentiment collapse, and financial conditions tighten. Another mistake may be in the offing.
There is however an important change afoot.
In 2011, in the thick of the euro-zone financial crisis when Mario Draghi became the ECB President, he and the institution were effectively the glue holding the Union together. Many of the deep political and policy relationships at the EU were forged during the euro-zone crisis and helped to build the sense of solidarity that carried through to negotiations with Britain on Brexit, and the urgency that is now manifest at the Commission level.
To that end the EU is now evolving at a rate and a magnitude that is still largely unappreciated. It has Vladimir Putin and to a lesser extent, Donald Trump to thank for imparting a sense of urgency to the EU’s strategic deliberations across foreign, energy and security policy in particular.
In the last week it has begun to show that it can take aim at electricity(gas) prices – something that individual states could not do on their own without surrendering their moral capital (with the exception of Hungary). The EU itself will not be able to kill off broad inflation – that is the job of the ECB – but it can certainly curb the pernicious effects of the weaponization of energy by Russia, and in so doing avoid misery and the risk of social unrest. It may also need a coordinated framework for the institutional support of utilities and energy producers, many of whom are as financially stressed as the sub-prime sector was in 2009.
My own sense is that the ‘winter energy’ chaos that some speak of will not materialize in as extreme a manner as feared (nuclear, hydro powered electricity are rebounding in capacity), and that the ultimate consequence of the spike in gas prices will be to destroy the largest source of demand for Russian energy.
In that context, the EU will emerge stronger and better prepared from this crisis, in the same way as it has done in the aftermath of Brexit. As it evolves, the ECB should also examine how it can improve and adapt to a changing world.
Here I want to reiterate a few suggestions I have made in recent years, starting with diversity. Central banking is not a diverse place, made up mostly of middle-aged males. What is more telling is that all of these males, and the growing number of females that join them, are formed in the same way and look at the world in a similar fashion.
Most of the members of the policy committees of the Fed and ECB have spent their careers in central banking circles, with the odd jaunt in and out of academia. As a result there is little diversity of experience at the top of the main central banks, and central bankers are not well socialized to the implications of their policies on the outside world. In the future, in addition to greater gender diversity, it may well be useful for central banks to appoint decision makers with a greater variety of experience across industry and other related walks of life.
A really important sub-element here is to appoint policy makers with a sense of the consequences of their actions, and an ability to alter their view when it is wrong. Forecasting as they say is hard, especially when it is about the future and to a large extent the role of the central banker is about mapping and creating a vision of the economic future.
Where this vision jars with reality, policy makers should ideally be conditioned to rethink their positions or be equipped with simple devices like the Bank of England Governor’s ‘letter to the Chancellor’ (the Governor must write an explanatory letter to the Chancellor if inflation deviates from target by over 1%).
A further innovation, at least for the ECB is to give local central banks more autonomy over their economies. This will take a degree of experimentation but the idea is that depending on the structure of an individual economy (compare Ireland and Greece to Texas and Kansas), specific macro-prudential policy levers could be developed to cool or speed up local economies in the context of overall monetary policy.
My pessimistic conclusion is that many of these and other suggestions will have to wait until the next recession to get a hearing, when central banks start to prosecute QE4 to undo their most recent mistake.